Growth companies and MiFID II: The painkiller prescription nobody saw coming
By Dan Campbell; Jaqi Hummel; Charlotte Longman; Andrew Poole, ACA Group
Published: 18 September 2023
The Markets in Financial Instruments Directive (MiFID II) is not a new regulation, it is not even a new iteration of a regulation, but aspects of this European directive, particularly the ‘unbundling’ of research from execution services, are like a headache that won’t go away. A major contributor to this pain is the different treatment of payments for research on either side of the Atlantic.
In October 2017, the US Securities and Exchange Commission (SEC) provided a painkiller ahead of the 2018 implementation of MiFID II, by issuing a “no-action” letter allowing US broker-dealers to provide investment research to European Union (EU) domiciled clients in return for ‘hard dollars’, without having to register as investment advisers.
In late 2019, an additional dose of painkiller was administered as this no-action relief was extended for a further three years, setting the expiration date of 3 July 2023. As the UK and the EU look to invigorate investment into growth companies, however, further painkillers may no longer be necessary.
There has been a lot of press about the lack of investment from UK sources in UK growth companies recently, including the trend of firms listing on US exchanges rather than the London Stock Exchange. While somewhat embarrassing for the UK Government, Chancellor Jeremey Hunt addressed these concerns in his recent Mansion House speech. He unveiled reforms to the UK pension scheme sector, aimed at unleashing an estimated £75 billion in investments into UK Unlisted Equity. This includes an agreement with the nine largest defined contribution (DC) pension scheme providers, covering roughly 75% of the DC schemes, to increase their allocation to unlisted equities from 1% currently to at least 5% by 2030.
To further support this investment, and bringing us back to the MiFID II painkillers, the UK will also continue to reform its approach to the inducement rules brought into force through the regulation.
Having already declared that research across the Fixed Income, Currency and Commodities (FICC) sector, along with SMEs (small, medium, enterprises) with a £200 million market capitalisation, would be exempt from the FCA inducement rules, the Chancellor announced the UK Financial Conduct Authority (FCA) would start immediately engaging with the market to remove the ‘unbundling’ requirements. He noted that the Government had accepted the recommendations of Rachel Kent’s UK Investment Research Review, which include allowing asset managers to pay for research out of their own resources, charge clients directly, or combine the cost of research with execution charges, which was allowed prior to MiFID II.
In an entirely coincidental quirk of timing, the EU is also looking at ‘re-bundling’ research in an effort to invigorate investments. As mentioned, the UK set a market capitalisation at £200 million when amending the inducement rules. The EU, however, went a little further, establishing the threshold of €1 billion market capitalisation as the limit above which the inducement rules would still be in effect.
As part of amendments proposed in December 2022, market capitalisation is set to be increased to €10 billion and would be applicable at the pre-IPO stage. Both the EU and the UK argue that removal of the unbundling requirements is essential to ensure that in-depth, quality research is more readily available and thus provide greater access to the capital markets for SMEs looking for funding. With the recent increases in cost of debt funding, this in turn may provide cheaper financing to smaller cap and growth companies.
The US regulatory framework, in direct contradiction to the general European trend, has never been particularly concerned about including research and execution services as a package. Indeed, under US law, a broker-dealer who receives separate hard dollar payments for research could be deemed an investment adviser and required to register with the SEC as such, subjecting them to yet another set of regulations under the Advisers Act. And so, the MiFID II headache was brought on for US Broker-Dealers engaging with firms caught under the European directive.
Though the adjustments made by the FCA and UK alleviated the headache slightly in 2022, a speech by William Birdthistle, director of the SEC Division of Investment Management in July 2022, did not provide too much additional comfort. He said the “Division does not intend to extend the temporary position beyond its current expiration date in July 2023,” setting the clock ticking towards the 3 July deadline.
While some broker-dealers dealt with the issue by becoming dually registered or using a registered adviser affiliate to provide research services, these options may not have been palatable, or even possible, for some. Generally, most US broker-dealers believe that registering as an investment adviser is not a viable solution to the conflicts of interest challenges that they would face under the US Investment Advisers Act of 1940 in connection with the MiFID II unbundling requirement.
The only other practical option would be to shift hard dollar payments to an affiliated, but separately organised business entity in the UK for non-US clients, to comply with regulations enacted under MiFID II, while also segmenting soft dollar payment operations in the US affiliate for the benefit of US clients. However, this approach could raise questions about the extraterritorial application of US law that may limit the availability of US advice. Overall, there is a concern that the expiration of the no-action relief will put US broker-dealers at a competitive disadvantage to their non-US peers and to US peers with a European presence.
3 July came and went and with it the expiration of the “no-action” letters. It is noteworthy that SEC Commissioner Mark Uyeda issued a public statement shortly afterward describing his disappointment that the SEC did not extend the no-action relief for a modest additional time period to accommodate the potential changes, highlighting the possible challenges this will create for US broker-dealers to provide research to asset managers subject to MiFID II.
Though potential relief via the UK and European adjustments is on the horizon, or perhaps just over it, given the inevitable bureaucratic steps that will be required, the old headache once again returned. The SEC’s refusal to extend this relief has drawn criticism from the markets and there appears to be an overwhelming desire for it to be extended indefinitely.
It is therefore no surprise that trade bodies, such as Securities Industry and Financial Markets Association (SIFMA), heaped praise on the US House of Representatives for passing a bill on 11 July (just over a week after the final expiry of the no action letter), which directs the SEC to extend the MiFID II no-action relief for a further six months. The proposals are now on their way to the Senate’s Committee on Banking, Housing and Urban affairs before potentially and ultimately being enacted.
It’s possible that this extension could cure the MiFID II Research question for good in the US, given the changes being considered across the Atlantic. By the time the US relief expires (again), the changes that caused the conflict may be repealed or changed beyond recognition, and the conflict of law with the Advisers Act no longer exists.
Though questions remain about how badly growth companies have been impacted by the apparent restricted access to research, resolving this five-year headache will come as a welcome relief. As inflation appears to be slowly coming under control, or at least no longer increasing, attention can turn to assessing the growth market for future investments and identifying the companies of the future. With legislative changes clearly signposted, and political winds blowing in potentially different directions, there will no doubt be plenty of opportunity to dig out those painkillers once again.
1 Statement on the Expiration of the SEC Staff No-Action Letter re: MiFID II, Commissioner Mark T. Uyeda, July 5, 2023.